Home Fundamental Analysis Explained Evaluate Stock Price With Reverse-Engineering DCF

1/10/2012 2:09:56 AM

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If you’ve ever thumbed through a stock analysts’ report, you will have probably come across a stock valuation technique called discounted cash flow analysis. or DCF for short. DCF entails forecasting future company cash flows, applying a discount rate according to the company’s risk, and coming up with a precise valuation or target price for the stock.

The trouble is that the job of predicting future cash flows requires a healthy dose of guesswork. However, there is a way to get around this problem. By working backwards — starting with the current share price — we can figure out how much cash flow the company would be expected to make in order to generate its current valuation. Depending on the plausibility of the cash flows, we can decide whether the stock is worth its going price. (If you’re unfamiliar with the DCF method, make sure you check out our DCF Analysis Tutorial .)

DCF Sets Target Prices

There are basically two ways of valuing a stock. The first, relative valuation involves comparing a company with others in the same area of business, often using a price ratio such as price/earnings, price/sales, price/book value and so on. It is a good approach for helping analysts decide whether a stock is cheaper or more expensive than its peers. However, it’s a less reliable method of determining what the stock is really worth on its own. (Learn more about valuation ratios in our Investment Valuation Ratios Tutorial . )

As a consequence, many analysts prefer the second approach, DCF analysis, which is supposed to deliver an absolute valuation or bona fide price on the stock. The approach involves explaining how much free cash flow the company will produce for investors, over, say, the next 10 years, and then calculating how much investors should pay for that stream of free cash flows based on an appropriate discount rate. Depending on whether it is above or below the stock’s current market price, the DCF-produced target price tells investors whether the stock is currently overvalued or undervalued.

In theory, DCF sounds great, but like ratio analysis, it has its fair share of challenges for analysts. Among the challenges is the tricky task of coming up with discount rate, which depends on a risk-free interest rate. the company’s cost of capital and the risk its stock faces.

But an even bigger problem is forecasting reliable future free cash flows. While trying to predict next year’s numbers can be hard enough, modeling precise results over a decade is next to impossible. No matter how much analysis you do, the process usually involves as much guesswork as science. What’s more, even a small, unexpected event can alter cash flows and make your target price obsolete.

Reverse-Engineering DCF

Discounted cash flow, however, can be put to use in another way that gets around the tricky problem of accurately estimating future cash flows. Rather than starting your analysis with an unknown, a company’s future cash flows, and trying to arrive at a target stock valuation, start instead with what you do know with certainty about the stock: its current market valuation. By working backwards, or reverse-engineering the DCF from its stock price, we can work out the amount of cash that the company will have to produce to justify that price.

If the current price assumes more cash flows than what the company can realistically produce, then we can conclude that the stock is overvalued ; if the opposite is the case, and the market’s expectations fall short of what the company can deliver, then we should conclude that it’s undervalued .

An Example

Here’s a very simple example of how to think through a reverse-engineered DCF. Consider a company that sells widgets. We know for certain that its stock is at $14.00 per share and, with a total share count of 100 million, the company has a market capitalization of $1.4 billion. It has no debt and we assume that its cost of equity is 12%. This year the company delivered $5 million in free cash flow.

What we don’t know is how much the company’s free cash flow will have to grow year after year for 10 years to justify its $14.00 share price. To answer the question, let’s employ a simple 10-year DCF forecast model that assumes the company will be able sustain a long term cash flow growth rate (also know as the terminal growth rate) of 3.0% after 10 years of more rapid growth. Of course, you can create multi-stage models that incorporate varying growth rates through the 10-year period, but for the purpose of keeping things simple, let’s stick to a single stage model.

Instead of setting up the DCF calculations yourself, there are usually spreadsheets already available that only require the inputs. So using a DCF spreadsheet, we can reverse-engineer the necessary growth back to the share price. (To follow along in the example, use this DCF Template . )

Take the inputs that are already known: $5 million in initial free cash flow, 100 million shares, 3% terminal growth rate, 12% discount rate (assumed) and plug the appropriate numbers into the spreadsheet. After entering the inputs, the goal is to change the growth rate percentage in years 1-5 and 6-10 that will give you an intrinsic value per share (IV/share) of approximately $14. After a bit of trial and error, we come up with a 50% growth rate for the next 10 years which results in a $14 share price. In other words, pricing the stock at $14 per share, the market is expecting that the company will be able to grow its free cash flow by about 50% per year for the next 10 years. (One of the inputs that may be confusing is the discount rate or cost of equity; to learn how you would come up with an appropriate discount rate check out The Capital Asset Pricing Model: An Overview .)

The next step is to apply your own knowledge and intuition to judge whether 50% growth performance is reasonable to expect. Looking at the company’s past performance, does that growth rate make sense? Can we expect a widget company to more than double its free cash flow output every two years? Will the market be big enough to support that level of growth? Based on what you know about the company and its market, does that growth rate seem too high, too low, or just about right? The trick is to consider as many different plausible conditions and scenarios until you can say with confidence that the market’s expectations are correct or not and whether you should invest in it or not.

Conclusion

Reverse-engineered DCF doesn’t eliminate all the problems of DCF, but it sure helps. Instead of hoping that our free cash flow projections are correct and struggling to come up with a precise value for the stock, we can work backwards using information that we already know in order to make a general judgment about the stock’s value.

Of course, the technique doesn’t completely free us from the job of estimating cash flows. To assess the markets expectations, you still need to have a good sense of what conditions are required for the company to deliver them. That said, it is a much easier task to judge the plausibility of a set of forecasts rather than having to come up with them your own. Try it for yourself.

Ben McClure is a long-time contributor to Investopedia.com.

Ben is the director of Bay of Thermi Limited, an independent research and consulting firm that specializes in preparing early stage ventures for new investment and the marketplace. He works with a wide range of clients in the North America, Europe and Latin America. Ben was a highly-rated European equities analyst at London-based Old Mutual Securities, and led new venture development at a major technology commercialization consulting group in Canada. He started his career as writer/analyst at the Economist Group. Mr. McClure graduated from the University of Alberta’s School of Business with an MBA.